2

SUPPLY AND DEMAND I: HOW MARKETS WORK

 4
The Market Forces of
Supply and Demand
 Trade and Markets
• In the last chapter we saw that trade can be a
good thing
• But, when trade takes place, at what price will
the trade take place
• What are the factors that determine the price
• These are the questions that this chapter is
about
 Why are Prices Important?
• To try to predict the economic effect of some
specified event you would ultimately have to
understand how the behavior of individual
consumers and firms would be affected
• These changes in behavior depend largely on
changes in prices
• Therefore, if you can’t predict the event’s effect
on prices you’ll get stuck
 MARKETS AND COMPETITION
• A market is a group of buyers and sellers of a
particular good or service.

• The terms supply and demand refer to the

behavior of people . . . as they interact with one
another in markets.
Competitive Markets

• This chapter discusses a theory of prices. But

the theory discussed here is true only when
markets are perfectly competitive
• A competitive market is a market in which
• there are many buyers
• many sellers
• And all sellers sell the exact same product
• As a result, each buyer and seller has a
negligible impact on the market price
Imperfect Competition

• Monopoly
• One seller, and seller controls price
• Oligopoly
• Few sellers
• Not always aggressive competition
• Monopolistic Competition
• Many sellers
• Slightly differentiated products
 Prices Under Perfect Competition
• The Theory of Supply and Demand is a simple
way of predicting the effect of a specified event
on the price of some specified commodity…
• …provided the market for that commodity is
perfectly competitive
 DEMAND
• Quantity demanded is the amount of a good
that buyers are willing and able to purchase
• Demand is a full description of how the
quantity demanded changes as the price of the
good changes.
 Demand: schedule and curve
• There are two common ways of representing
demand:
• The demand schedule
• The demand curve
The Demand Schedule: The Relationship
between Price and Quantity Demanded
• The demand schedule is a table that shows the
relationship between the price of the good and
the quantity demanded
Catherine’s Demand Schedule
The Demand Curve: The Relationship
between Price and Quantity Demanded
• The demand curve is a graph of the
relationship between the price of a good and the
quantity demanded
Figure 1 Catherine’s Demand Schedule and Demand
Curve

Price of
Ice-Cream Cone
$3.00

2.50

1. A decrease
2.00
in price ...

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity
of cones demanded.
Copyright © 2004 South-Western
Demand and Quantity Demanded

Quantity
Demanded
when Price is
$0.50.

Quantity
Demanded
when Price is
$2.50.
 Demand and Quantity Demanded
• Note that Quantity Demanded changes when
the Price changes
• But Demand, being the entire table inside the
red border, does not
Demand and Quantity Demanded
Price of
Ice-Cream Cone
$3.00

2.50

2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Quantity Ice-Cream Cones
Demanded,
… and when
when Price is
Price is $0.50.
$2.50 …
 Demand and Quantity Demanded
• Note that Quantity Demanded changes when
the Price changes
• But Demand, being the entire curve inside the
red border, does not
 Law of Demand
• The law of demand states that, other things
equal, the quantity demanded of a good falls
when the price of the good rises
 “Other things equal”
• That’s an important phrase in the wording of the Law
of Demand
• The quantity demanded of a consumer good such as
ice cream depends on
• The price of ice cream
• The prices of related goods
• Consumers’ incomes
• Consumers’ tastes
• Consumers’ expectations about future prices and incomes,
etc
• The Law of Demand says that the quantity demanded
of a good is inversely related to its price, provided all
other factors are unchanged
The Law of Demand—Explanations
• There are two ways to explain the Law of
Demand
• Substitution effect
• Income effect
Substitution Effect
Income Effect
Market Demand versus Individual Demand

• Market demand refers to the sum of all

individual demands for a particular good or
service.
• Graphically, individual demand curves are
summed horizontally to obtain the market
demand curve.
Figure 2 Market Demand as the
Sum of Individual Demands
 A Shift in Mary’s Demand
Quantity Demanded • How can we
Price Situation A Situation B explain the
0.00 12 20 difference in
0.50 10 16 Mary’s behavior in
1.00 8 12 situations A and B?
1.50 6 8 • Why does she
2.00 4 6 consume more in
2.50 2 4 situation B at any
3.00 0 2 given price?
Shifts in the Market Demand Curve

• … are caused by changes in:

• Consumer income
• Prices of related goods
• Tastes
• Expectations
• Number of buyers
 Figure 3 Shifts in the Demand Curve

Price of
Ice-Cream
Cone

Increase
in demand

Decrease
in demand
Demand
curve, D2
Demand
curve, D1
Demand curve, D3
0 Quantity of
Ice-Cream Cones
Shifts in the Demand Curve

• Consumer Income
• As income increases the demand for a normal good
will increase
• As income increases the demand for an inferior
good will decrease
 Consumer Income
Normal Good
Price of Ice-
Cream Cone
$3.0 An increase
0
2 in income...
.50 Increase
2 in demand
.00
1
.50
1
.00
0
.50
D2
D1 Quantity
of Ice-
0 1 2 3 4 5 6 7 8 9 10 11 12 Cream
Cones
 Consumer Income
Inferior Good
Price of Ice-
Cream Cone
$3.0
0
2 An increase
.50
2
in income...
.00 Decrease
1 in demand
.50
1
.00
0
.50
D2 D1 Quantity of
Ice-Cream
0 1 2 3 4 5 6 7 8 9 10 11 12 Cones
Shifts in the Demand Curve

• Prices of Related Goods

• When a fall in the price of one good reduces the
demand for another good, the two goods are called
substitutes
• When a fall in the price of one good increases the
demand for another good, the two goods are called
complements
Table 1 Variables That Influence
Buyers
 Figure 4 Shifts in the Demand
Curve versus Movements along the
Demand Curve
 SUPPLY
• Quantity supplied is the amount of a good that
sellers are willing and able to sell
• Law of Supply
• The law of supply states that, other things equal, the
quantity supplied of a good rises when the price of
the good rises
The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Schedule
• The supply schedule is a table that shows the
relationship between the price of the good and the
quantity supplied
Ben’s Supply Schedule
The Supply Curve: The Relationship between
Price and Quantity Supplied
• Supply Curve
• The supply curve is the graph of the relationship
between the price of a good and the quantity
supplied
 Figure 5 Ben’s Supply Schedule and Supply Curve

Price of
Ice-Cream
Cone
$3.00

2.50
1. An
increase
in price ... 2.00

1.50

1.00

0.50

0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of
Ice-Cream Cones
2. ... increases quantity of cones supplied.
Market Supply versus Individual Supply

• Market supply refers to the sum of all

individual supplies for all sellers of a particular
good or service.
• Graphically, individual supply curves are
summed horizontally to obtain the market
supply curve.
Figure 6 Market Supply as the Sum
of Individual Supplies
Figure 6 Market Supply as the Sum
of Individual Supplies
Shifts in the Supply Curve

• Input prices
• Technology
• Expectations
• Number of sellers (short run)
Shifts in the Supply Curve

• Change in Quantity Supplied

• Movement along the supply curve
• Caused by a change in anything that alters the
quantity supplied at each price
 Change in Quantity Supplied
Price of Ice-
Cream S
Cone
C
$3.0
0 A rise in the price
of ice cream
cones results in a
movement along
A the supply curve.
1.00

Quantity of
Ice-Cream
0 1 5 Cones
 Law of Supply—Explanation
• The Law of Supply comes from the assumption
called Decreasing Returns or Increasing Costs.
Shifts in the Supply Curve

• Change in Supply
• A shift in the supply curve, either to the left or right
• Caused by a change in a determinant other than
price
 Figure 7 Shifts in the Supply Curve

Price of
Ice-Cream Supply curve, S3
Supply
Cone
curve, S1
Supply
Decrease curve, S2
in supply

Increase
in supply

0 Quantity of
Ice-Cream Cones
Table 2 Variables That Influence Sellers
 SUPPLY AND DEMAND
TOGETHER
• Equilibrium refers to a situation in which the
price has reached the level where quantity
supplied equals quantity demanded
 SUPPLY AND DEMAND
TOGETHER
• Equilibrium Price
• The price that balances quantity supplied and
quantity demanded
• On a graph, it is the price at which the supply and
demand curves intersect
• Equilibrium Quantity
• The quantity supplied and the quantity demanded at
the equilibrium price
• On a graph it is the quantity at which the supply and
demand curves intersect
 SUPPLY AND DEMAND
TOGETHER
Demand Supply
Schedule Schedule

At $2.00, the quantity demanded

is equal to the quantity supplied!
 Figure 8 The Equilibrium of Supply and Demand

Price of
Ice-Cream
Cone Supply

Equilibrium price Equilibrium

$2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Figure 9 Markets Not in Equilibrium

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones
Equilibrium

• Surplus
• When price exceeds equilibrium price, then quantity
supplied is greater than quantity demanded
• There is excess supply or a surplus
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium
Equilibrium

• Shortage
• When price is less than equilibrium price, then
quantity demanded exceeds the quantity supplied
• There is excess demand or a shortage
• Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
equilibrium
Figure 9 Markets Not in Equilibrium

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones
Equilibrium

• Law of supply and demand

• The claim that the price of any good adjusts to bring
the quantity supplied and the quantity demanded for
that good into balance
• Although the Law of Supply and Demand is a
good place to start the discussion of prices, it
should not be taken to be the gospel truth. In
some cases the price might get stuck at some
other level and quantity supplied and quantity
demanded may not be equal. Example:
unemployment
Three Steps to Analyzing Changes in
Equilibrium due to some specified event
• Decide whether the event shifts the supply or
demand curve (or both).
• Decide whether the curve(s) shift(s) to the left
or to the right.
• Use the supply-and-demand diagram to see how
the shift affects equilibrium price and quantity.
 Figure 10 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . . resulting Initial
in a higher equilibrium
price . . .
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold.
Three Steps to Analyzing Changes in
Equilibrium
• Shifts in Curves versus Movements along
Curves
• A shift in the supply curve is called a change in
supply
• A movement along a fixed supply curve is called a
change in quantity supplied
• A shift in the demand curve is called a change in
demand
• A movement along a fixed demand curve is called a
change in quantity demanded
 Figure 11 How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream 1. An increase in the
Cone price of sugar reduces
the supply of ice cream. . .
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. . . . resulting
in a higher
price of ice
cream . . . Demand

0 4 7 Quantity of
3. . . . and a lower Ice-Cream Cones
quantity sold.
Figure 12 A Shift in Both Supply and
Demand
Table 4 What Happens to Price and Quantity When Supply
or Demand Shifts?
 Summary
• Economists use the model of supply and
demand to analyze competitive markets.
• In a competitive market, there are many buyers
and sellers, each of whom has little or no
influence on the market price.
 Summary
• The demand curve shows how the quantity of a
good depends upon the price.
• According to the law of demand, as the price of a
good falls, the quantity demanded rises. Therefore,
the demand curve slopes downward.
• In addition to price, other determinants of how
much consumers want to buy include income, the
prices of complements and substitutes, tastes,
expectations, and the number of buyers.
• If one of these factors changes, the demand curve
shifts.
 Summary
• The supply curve shows how the quantity of a
good supplied depends upon the price.
• According to the law of supply, as the price of a
good rises, the quantity supplied rises. Therefore,
the supply curve slopes upward.
• In addition to price, other determinants of how
much producers want to sell include input prices,
technology, expectations, and the number of sellers.
• If one of these factors changes, the supply curve
shifts.
 Summary
• Market equilibrium is determined by the
intersection of the supply and demand curves.
• At the equilibrium price, the quantity demanded
equals the quantity supplied.
• The behavior of buyers and sellers naturally
drives markets toward their equilibrium.
 Summary
• To analyze how any event influences a market,
we use the supply-and-demand diagram to
examine how the even affects the equilibrium
price and quantity.
• In market economies, prices are the signals that
guide economic decisions and thereby allocate
resources.